Trader Arrested in Manipulation Tha...
Trader Arrested in Manipulation That Contributed to 2010 'Flash Crash'
Five years ago, the global financial system was rocked by the "flash crash," 15 minutes of chaos that shook the world's biggest markets and prompted investors both big and small to question how such a vital part of the economy could be brought to its knees.
On Tuesday, United States prosecutors said that much of the blame for the event could be pinned on a single person: a 36-year-old man who had been boldly manipulating markets from his suburban rowhouse just a few minutes from Heathrow Airport outside London, where he was arrested.
Regulators said that their prosecution of the trader, Navinder Singh Sarao, demonstrated their aggressiveness in rooting out market manipulation. But news of the arrest, if anything, has raised anew concerns about how an individual could manage to exert such influence over the world's financial markets. The case also played into worries that have swirled around the increasingly automated and complex financial markets, where regulators have struggled to keep up with nimble new participants like high-frequency trading firms that use sophisticated networks to make money in milliseconds via rapid-fire trades.
For the latest case, it took the authorities five years to track down a rogue actor making enormous trades. And, they were led to him only with the help of an outside whistle-blower.
"I'm dumbfounded that they missed this until now," said Eric Hunsader, founder of the market data company Nanex, who has been critical of the regulatory efforts to crack down on problematic high-frequency trading.
Mr. Sarao is accused of entering and withdrawing thousands of orders worth tens of millions of dollars each on hundreds of trading days, in an attempt to push down the price of futures contracts tied to the value of the Standard & Poor's 500-stock index, a practice known as spoofing. Once the price fell, Mr. Sarao would buy the contract and reap the profits, according to the criminal complaint.
On the day of the flash crash on May 6, 2010, prosecutors contend that Mr. Sarao placed large orders repeatedly over several hours, leaving the market vulnerable to big moves when another big trade came in from an investor in the United States.
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At about 2:40 p.m. that day, the falling price of the futures contract that Mr. Sarao was trading spread to other related markets. Soon, the Dow Jones industrial average, which represents 30 of the largest American companies, was in a virtual free fall, dropping nearly 600 points in a matter of minutes. Although the major indexes recovered most of the losses, the event was blamed for shaking the confidence of ordinary Americans who put their savings into the stock market.
Mr. Sarao, who was in British custody on Tuesday pending an extradition request from the United States, faces charges of wire fraud and commodities fraud among other counts.
A lawyer for the Commodity Futures Trading Commission, which oversees the futures markets, said that the agency was not pinning the blame on the crash solely on Mr. Sarao.
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"I'm not ready to go that far," said Aitan Goelman, director of enforcement at the commission. But he added that Mr. Sarao's actions played a noticeable role. "His conduct was significantly responsible for the order unbalance, which was one of the conditions that led" to the crash, Mr. Goelman said in a call with journalists.
Prosecutors said that Mr. Sarao made $40 million trading the same futures contracts over four years.
Mr. Sarao's lawyer could not be identified on Tuesday.
In addition to the criminal case against Mr. Sarao, the future commission unsealed its own civil suit against him on Tuesday. But the case represents something of a humbling acknowledgment for the C.F.T.C., which was one of the regulatory agencies that wrote a 104-page report about the flash crash in September 2010 but did not, at the time, identify Mr. Sarao's trades as a cause of the problems.
Mr. Sarao, for his part, was not shy about dropping hints about his intentions. A month before the flash crash, in April 2010, Mr. Sarao set up a corporate entity in the Caribbean island of Nevis, the criminal complaint said, and was so brash as to embed in his firm name — Nav Sarao Milking Markets — his motivations.
The complaint against Mr. Sarao, filed in Chicago, could be particularly problematic for the Chicago Mercantile Exchange, which is one of the world's largest trading arenas and handled the trades in question.
Mr. Sarao had faced questions from the exchange about his trading activity long before the flash crash. But there are no indications that the exchange ever took action against him, and Mr. Sarao continued trading in much the same way until this month, the complaint said. At one point in 2010, Mr. Sarao said in an email that he had called the exchange, in response to its questions, "and told 'em to kiss my ass."
The Chicago exchange and other American exchanges have come under scrutiny because they are tasked with policing their members but rely on those same members for revenues, creating an incentive to not come down too hard on them.
The Chicago Mercantile Exchange, which handles trading in options and futures contracts, said it could not comment on the case because the inquiry is continuing.
In the end, the government found Mr. Sarao after a whistle-blower went to the C.M.E.'s federal regulator, the Commodity Futures Trading Commission. This whistle-blower, who is remaining anonymous publicly but is known to American regulators, went to the commission "after hundreds of hours spent analyzing data and other information," according to a lawyer representing the person.
Federal authorities have been under more pressure to identify malicious behavior in the markets since last spring, when the author Michael Lewis published "Flash Boys," which drew much public attention to the potential problems created by high-frequency traders.
Since then, the authorities appear to have stepped up their scrutiny of the markets and have taken more aggressive action against bad actors. Mr. Hunsader, the founder of Nanex who has been critical of the regulators, said that the legal actions do appear to have "put the fear of God" in many market participants, though he said the type of manipulation that Mr. Sarao is being accused of is still common.
The case will play into the heated debate over whether investors have been hurt by the increasing presence of high-speed traders, who account for more than half of the activity in most of the largest trading markets.
Since the flash crash, there have been a number of other disruptive events that have unnerved investors, including the implosion of Knight Capital, after a faulty algorithm caused the company to lose more than $400 million in under an hour.
Last fall, the market for Treasury securities, where the United States government raises billions of dollars, was rocked by a brief but wild rise in the price of the 10-year Treasury note. Just this month, though, academics at Columbia released the findings of a study of the stock market. They found that aside from the occasional disruptions, industry automation and the sophisticated tactics of high-frequency traders have not come at the expense of ordinary investors.
Lawrence R. Glosten, one of the authors of the paper, and a professor at Columbia Business School, said he did not believe that the behavior of people like Mr. Sarao is likely to be terribly damaging to the markets, but he added that there had not been enough inquiry into how common such manipulation may be.
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